Fed Concerned About Overheated Markets Amid Record Bond Buys

Federal Reserve Chairman Chairman Ben S. Bernanke is on the lookout for financial distortions that may reverse abruptly when the Fed stops adding to its portfolio. Photographer: Andrew Harrer/Bloomberg

Jan. 17 (Bloomberg) -- Federal Reserve officials are
voicing increased concern that record-low interest rates are
overheating markets for assets from farmland to junk bonds,
which could heighten risks when they reverse their unprecedented
bond purchases.

Investors have been snapping up riskier assets since the
Fed boosted its bond buying to reduce long-term borrowing costs
after cutting its overnight rate target close to zero in
December 2008. Enthusiasm for speculative-grade bonds is at
unprecedented levels, driving a Credit Suisse index that tracks
the yield on more than 1,500 issues to a record-low 5.9 percent
last week.

Now, as central bankers boost their stimulus with
additional bond purchases, policy makers from Chairman Ben S.
Bernanke to Kansas City Fed President Esther George are on the
lookout for financial distortions that may reverse abruptly when
the Fed stops adding to its portfolio and eventually shrinks it.

“Prices of assets such as bonds, agricultural land, and
high-yield and leveraged loans are at historically high
levels,” George said in a speech last week. “We must not
ignore the possibility that the low-interest rate policy may be
creating incentives that lead to future financial imbalances.”

Bernanke himself raised that concern this week, saying the
central bank has to “pay very close attention to the costs and
the risks” of its policies during a Jan. 14 discussion at the
University of Michigan’s Gerald R. Ford School of Public Policy
in Ann Arbor.

Credit Easing

The Fed is purchasing as much as $85 billion a month of
bonds, a pace that would balloon its balance sheet to more than
$3 trillion by the end of this year. Bernanke calls his debt
purchases “credit easing,” intended to push investors into
riskier assets to lower costs for borrowers.

Dennis Lockhart, president of the Atlanta Fed, said today
he sees a “legitimate concern” in the growth of the Fed’s
balance sheet with the additional purchases of mortgage-backed
bonds and Treasuries.

The expansion also poses greater challenges for the central
bank’s eventual withdrawal of stimulus, Lockhart said in an
interview in New York today at the Bloomberg Global Markets
Summit hosted by Bloomberg Link.

Lockhart Comfortable

“I’m very comfortable that when the time comes,” the exit
“can be carried out in an orderly way,” Lockhart said. Still,
“the bigger the balance sheet, the more the unknown factor.”

While the central bank has set no limit on the duration or
size of its bond-buying, several Federal Open Market Committee
members said at a December meeting it would “probably be
appropriate” to slow or stop purchases “well before” the end
of 2013 because of financial stability concerns.

The first sign of Fed tightening may set off a hair trigger
in the bond market, said Drew Matus, senior U.S. economist at
UBS Securities LLC in Stamford, Connecticut.

“There is no pulling back a little,” he said. When the
Fed begins to shrink its portfolio, investors will start to
price in the entire stock of bonds coming back into the market.
“It is always going to be hard to disengage in a very gradual
manner.”

Riskier Assets

An analysis by the Center for Financial Stability shows why
low yields are pushing investors to seek out riskier assets such
as stocks: The price they are paying for income from bonds
versus stocks is close to the highest level since 1920,
according to the New York-based research organization that has
Nobel Laureate Myron Scholes on its advisory board.

At current prices, investors in Treasury 10-year notes
yielding 1.82 percent are paying 54 times the value of the
income to own the notes. By contrast, investors in the Standard
& Poor’s 500 stock index are paying just 14.8 times earnings,
strengthening the incentive to own stocks rather than bonds.

Investors snapping up junk bonds have driven yields to
record lows, according to some indexes, and below more senior
ranking loans. Credit Suisse’s index of junk-bond yields is down
from 8 percent a year ago. Junk bonds are rated below Baa3 by
Moody’s Investors Service and less than BBB- at Standard &
Poor’s and Fitch Ratings.

Junk bonds have returned 121.8 percent, including
reinvested interest, since the end of 2008, according to Bank of
America Merrill Lynch’s U.S. High Yield Index. That’s better
than the 78.1 percent gain for the S&P 500, when including
dividends.

Farmland prices in the Kansas City Fed’s district, which
covers western Missouri, Nebraska, Kansas, Oklahoma, Wyoming,
Colorado and northern New Mexico, set records in the third
quarter, according to the Fed bank’s Survey of Tenth District
Agricultural Credit Conditions.

Non-irrigated cropland prices were up 25 percent from a
year earlier and irrigated land values advanced more than 20
percent, according to the survey.

Market Distortions

“There are extreme market distortions occurring due to the
unusual monetary policy,” said Lawrence Goodman, president of
the Center for Financial Stability and the former director of
Quantitative Policy Analysis at the U.S. Treasury. “The upshot
is we are seeing increasing debate in FOMC meetings.”

The 59-year-old Bernanke, who helped the U.S. economy
weather the worst financial crisis since the Great Depression,
finishes his second term in a year and his legacy will be
defined partly by whether the Fed withdraws stimulus without
causing a collapse in markets that hurts economic growth.

Fed officials are “worried” and “working very hard on
trying to make sure that we are aware of where imbalances or
distortions are showing up and we don’t go too far down the road
before we try to address those,” Philadelphia Fed President
Charles Plosser said to reporters last week.

Lockhart said this week he is concerned about the markets
for Treasuries and mortgage-backed securities. The Fed each
month is buying $45 billion in Treasuries and $40 billion in
mortgage bonds.

Interrelated Markets

“Markets are highly connected and highly interrelated so a
severe spell of financial instability obviously would be much
broader than the markets in which we are making the purchases,”
Lockhart told reporters in Atlanta. He said he sees “no
immediate threats.”

Fed officials frame the debate in terms of costs and
benefits and for now see more benefits in trying to reduce
unemployment with further balance sheet expansion.

“They are still mostly in the mode of looking to support
the economy,” said Phillip Swagel, a former assistant secretary
for economic policy at the U.S. Treasury who is now a professor
at the University of Maryland’s School of Public Policy in
College Park.

“For them to take action to head off financial sector
froth when the economy is still weak is very difficult,” Swagel
said.

Still, the FOMC said last month that “readings on
financial developments” now weigh into how long it will sustain
stimulus at current levels.

England’s King

Central bankers elsewhere are also wary of excessive
valuations.

Bank of England Governor Mervyn King, whose benchmark
interest rate is 0.5 percent, told U.K. lawmakers on Jan. 15
that “the search for yield appears to be beginning again” and
merited monitoring. Bank of Canada Governor Mark Carney, who
will succeed King in London in July, has warned a rapid drop in
house prices is a major threat to the Canadian economy given
record household debt.

“Policy makers are right to worry about the risks to
financial stability from large-scale asset purchases,” said
Richard Barwell, a former Bank of England economist now at Royal
Bank of Scotland Group Plc. “There is a delicate balancing act
between providing much needed stimulus and encouraging another
search for yield with investors over-stretching themselves.”

Monitoring Conditions

Bernanke said this week that the central bank since the
financial crisis has “increased enormously the amount of
resources we put into monitoring financial conditions.”

Bernanke set up a new Office of Financial Stability Policy
and Research headed by Nellie Liang, an economist, to conduct
financial system surveillance. Daniel Tarullo, the Fed governor
in charge of bank supervision and regulation, established the
Large Institution Supervision Coordinating Committee (LISCC), a
group of economists, quantitative modelers, lawyers, payment
systems specialists and reserve bank supervisors who look for
risks among the largest financial institutions.

Both groups seek to identify the links between financial
firms that could rapidly spread instability, much like subprime
assets during the financial crisis last decade.

While saying officials need to be “open-minded” about how
monetary policy can lead to excessive valuations, Bernanke said
this week he considers supervisory tools “the first line of
defense” against asset-price bubbles.

“Sometimes we know a lot and the problem is we are not
acting on what we know,” said Bair, a senior adviser to The Pew
Charitable Trusts. “I worry that there is still too much”
inertia among supervisors of financial firms.